Foreclosure-gate: Servicers dupe investors, defraud homeowners

By davidpetraitis, on November 19th, 2010

Late last night I could only dip into this… Today I have read it through and found lots more interesting stuff from House testimony by Adam J. Levitin Associate Professor of Law Georgetown University Law Center. I have excerpted some of what I think are the best bits here:

Among the accusations brought against Countrywide in a recent investor notice of default filed by the Federal Reserve Bank of New York along with BlackRock and PIMCO, is that Countrywide has been padding expenses via in-sourcing on the 115 trusts covered by the letter….

It is important to emphasize that junk fees on homeowners ultimately come out of the pocket of MBS investors. If the homeowner lacks sufficient equity in the property to cover the amount owed on the loan, including junk fees, then there is a deficiency from the foreclosure sale. As many mortgages are legally or functionally non-recourse, this means that the deficiency cannot be collected from the homeowner’s other assets. Mortgage servicers recover their expenses off the top in foreclosure sales, before MBS investors are paid. Therefore, when a servicer lards on illegal fees in a foreclosure, it is stealing from investors such as pension plans and the US government.

And Professor Levitin goes on to assert that if (a sufficiently large) number of the securitizations fail to have proper title to the loans the loans fall back on the sponsoring banks books, and the must bear the weight of capital for the losses – which would make them insolvent. From the testimony:

While the chain of title issue has arisen first in foreclosure defense cases, it also has profound implications for MBS investors. If the notes and mortgages were not properly transferred to the trusts, then the mortgage-backed securities that the investors’ purchased were in fact non-mortgage-backed securities. In such a case, investors would have a claim for the rescission of the MBS,79 meaning that the securitization would be unwound, with investors receiving back their original payments at par (possibly with interest at the judgment rate). Rescission would mean that the securitization sponsor would have the notes and mortgages on its books, meaning that the losses on the loans would be the securitization sponsor’s, not the MBS investors, and that the securitization sponsor would have to have risk-weighted capital for the mortgages. If this problem exists on a wide-scale, there is not the capital in the financial system to pay for the rescission claims; the rescission claims would be in the trillions of dollars, making the major banking institutions in the United States would be insolvent. (sic)(my emphasis)

Last night I was at a risk management event and had one guy say to me that these people should be out of their houses if they can’t pay the mortgage. What Levitin calls the deadbeat/No harm No Foul defense:

A common response from banks about the problems in the securitization and foreclosure process is that it doesn’t matter as the borrower still owes on the loan and has defaulted. This “No Harm, No Foul” argument is that homeowners being foreclosed on are all a bunch of deadbeats, so who really cares about due process? As JPMorganChase’s CEO Jamie Dimon put it “for the most part by the time you get to the end of the process we’re not evicting people who deserve to stay in their house.”

Mr. Dimon’s logic condones vigilante foreclosures: so long as the debtor is delinquent, it does not matter who evicts him or how. (And it doesn’t matter if there are some innocents who lose their homes in wrongful foreclosures as long as “for the most part” the borrowers are in default.) But that is not how the legal system works. A homeowner who defaults on a mortgage doesn’t have a right to stay in the home if the proper mortgagee forecloses, but any old stranger cannot take the law into his own hands and kick a family out of its home. That right is reserved solely for the proven mortgagee….

The most basic rule of real estate law is that only the mortgagee may foreclosure. Evidence and process in foreclosures are not mere technicalities nor are they just symbols of rule of law. They are a paid-for part of the bargain between banks and homeowners. Mortgages in states with judicial foreclosures cost more than mortgages in states without judicial oversight of the foreclosure process. This means that homeowners in judicial foreclosure states are buying procedural protection along with their homes, and the banks are being compensated for it with higher interest rates. Banks and homeowners bargained for legal process, and rule of law, which is the bedrock upon which markets are built function, demands that the deal be honored.

Ultimately the “No Harm, No Foul,” argument is a claim that rule of law should yield to banks’ convenience. To argue that problems in the foreclosure process are irrelevant because the homeowner owes someone a debt is to declare that the banks are above the law.

He closes his testimony with some solid argumentation:

In the best case scenario, the problems in the mortgage market are procedural defects and they will be remedied within reasonably quickly (perhaps taking around a year). Remedying them will extend the time that properties are in foreclosure and increase the shadow housing inventory, thereby driving down home prices. The costs of remedying these procedural defects will also likely be passed along to future mortgage borrowers, thereby frustrating attempts to revive the housing market and the economy through easy monetary policy.

In the worst case scenario, there is systemic risk, as there could be a complete failure of loan transfers in private-label securitization deals in recent years, resulting in trillions of dollars of rescission claims against major financial institutions. This would trigger a wholesale financial crisis.

Perhaps the most important lesson from 2008 is the need to be ahead of the ball of systemic risk. This means (1) ensuring that federal regulators do a serious investigation as discussed in this testimony above and (2) considering the possible legislative response to a crisis. The sensible course of action here is to avoid gambling on unsettled legal issues that could have systemic consequences. Instead, we should recognize that stabilizing the housing market is the key toward economic recovery, and that it is impossible to fix the housing market unless the number of foreclosures is drastically reduced, thereby reducing the excess inventory that drives down housing prices and begets more foreclosures. Unless we fix the housing market, consumer spending will remain depressed, and as long as consumer spending remains depressed, high unemployment will remain and the US economy will continue in a doldrums that it can ill-afford given the impending demographics of retirement….

A critical point in any global settlement, however, must be removing mortgage servicers from the loan modification process. Servicers were historically never in the loan modification business on any scale, and four years of hoping that something would change have demonstrated that servicers never will manage to successfully modify many loans on their own. They lack the capacity, they lack the incentives, and the lack the will.

If we want to see more loan modifications—and I would submit that this is important not just as a type disaster relief for deserving homeowners, but as an indispensable measure for stabilizing the housing market and the economy—then we need to take servicers out of the loan modification process and have modifications done either by a government agency or by the courts or by outcome-neutral third parties.